Enhanced due diligence needed to avoid M&A fraud

With M&A volumes booming in Asia, the chances of fraud are also on the rise. EY argues would-be acquirers need to conduct forensic due diligence to minimise these risks.

Companies looking to buy in Asia and especially China should conduct forensic due diligence if they want to minimise the chance of overpaying for companies with overstated revenues and profits, or understated liabilities, believes consultancy EY.

With demand for mergers and acquisitions booming in Asia -- data provider Dealogic estimates that announced M&A volumes in the region have now reached $1.05 trillion year to date, up 61% on 2014 -- it is all the more crucial to pay closer attention to the financial detail, it thinks.

“Balance sheet fraud can be one of the most damaging types of fraud because it can have such a huge impact on a company’s valuation,” Chris Fordham, managing partner for fraud investigation and dispute services at EY, told FinanceAsia.

As a result, he advises would-be acquirers to spend time and money on people like him to do “deep dives” into their targets to unearth any suspicious activity. 

Corporate demand for EY’s forensic due diligence services is on the rise across Asia and Fordham’s division has grown to 180 people. Interest is particularly strong in China because of the amount of M&A activity taking place there, whether outbound, inbound, or domestic.

China accounts for approximately 30% of all Asia-Pacific outbound M&A, and 55% of domestic M&A in Asia-Pacific, according to Dealogic.

“There have been fraud risks previously in China but the deal sizes there are now the largest in Asia-Pacific,” Fordham said.

Worth the time

Fordham admitted that conducting more intensive due diligence research takes time and can be costly. However, it is more likely to reveal questionable activities than typical M&A due diligence checks of accountancy audits, he and his team argued.

“Normal due diligence relies a lot on information that is provided by the target, along with market knowledge and projections,” said Diana Shin, a Shanghai-based managing director for assurance in the Fordham’s department.  “I suggest buyers go beyond the target company’s information and consider the risk posed by its customers, partners, and suppliers as well.” 

These sort of checks can help reveal if there are fictitious or related parties put down as company customers, for example, or if sales orders are heavily inflated.

While they refused to name particular examples, Shin said EY had advised one client firm looking to acquire a potential Chinese company. Upon checking its customers, it became apparent that eight customer firms were based at residential addresses with no businesses based there, meaning the revenue assigned from these customers was probably a fraction of the amount claimed. It subsequently appeared the companies were parties related to the target corporate, so the acquirer ended up walking away from the negotiations.

The costs of fraud

US heavy machinery operator Caterpillar, for example, knows too well the costs of fraud in China. In January 2013, the company said it had discovered a multi-year accounting fraud at Siwei, China’s fourth-largest make or hydraulic roof supports. Siwei, a subsidiary of ERA Mining Machinery, was bought by Caterpillar for HK$5.06 billion ($653.4 million) in June 2012. As a result of the fraud, $580 million was wiped off the value of the acquisition.

Caterpillar released a statement when announcing the write-down, noting that after an investigation it “determined several Siwei senior managers engaged in deliberate misconduct beginning several years prior to Caterpillar's acquisition of Siwei.”

Activist investors have also become interested in conducting research to reveal cases of overstated valuations or sales, often in order to make money by shorting the company’s shares.

Canadian research company Muddy Waters did this with Sino-Forest, a China-based but Canada-listed logging and paper manufacturer in 2011. It attempted to do so too with Singapore commodity trader Olam before the company was rescued by state investment company Temasek, which raised its stake in the ailing and debt-laden firm.

US research group Glaucus conducts similar due diligence research and uncovered widespread fraud at China Metal Recycling Holdings, which led Hong Kong’s financial watchdog to suspend the company’s shares in January 2013.

Never too late

Shin argued that even after a company agrees to buy another and signs the necessary documentation, it can still embark on a forensic due diligence to put its mind at ease.

“It’s never too late to do your homework,” she said.

That can be especially helpful if the target has been thrifty with the amount of information it offered prior to the takeover.

“It’s important if a company does agree to acquire another that it demands accessibility to information after signing the documents and before closing the deal,” Shin said. “This process can still take several weeks to months.”

The two said the length of time a forensic due diligence takes can vary greatly because “no two companies are alike, so no two types of fraud are exactly alike,” Fordham said.

However he added that the types of fraud he typically unearths have predictable patterns, in that the protagonists either seek to overstate the revenues or profits of a business, or understate its liabilities or costs, with the aim of increasing its valuation.

Shin estimated that an initial look at a target company can take two to three weeks and that this can be enough to flag up questions over information. The acquirer then needs to decide whether they want to conduct a deeper dive.

“The conclusion is that if it sounds too good to be true, it usually is,” Fordham said. “Standard due diligence is not enough anymore; you need to conduct forensic due diligence too.”

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